Month: November 2010

Dodd-Frank Implementation Update

 

The Commodity Futures Trading Commission (“CFTC”) and Securities Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”) continue to meet with market participants and industry groups and to publish proposed rules and requests for comment related to the implementation of Title VII of the Dodd-Frank financial reform, titled the “Wall Street Transparency and Accountability Act of 2010” (the “Act”). The Act is generally intended to bring the $615 trillion over-the-counter derivatives market under greater regulation.  The CFTC, which will have primary responsibility for the regulation of “swaps” (as opposed to “security-based swaps,” which will be primarily regulated by the SEC), recently published proposed rules on various topics related to the Act, including: (i) conflicts of interest policies and procedures, registration requirements and governing duties of swap dealers and major swap participants; (ii) matters relating to compliance policies and annual reports for swap dealers and major swap participants; (iii) agricultural swaps; (iv) conflicts of interest requirements for derivatives clearing organizations (“DCOs”), designated contract markets and swap execution facilities; (v) reporting of pre-enactment swaps; (vi) financial resources requirements for DCOs; (vii) the process for review of swaps for mandatory clearing; (viii) the prohibition of market manipulation; (ix) registration of foreign boards of trade; and (x) antidisruptive practices authority.

The Commissions have received numerous comment letters and other input from firms, industry groups and other interested parties in connection with the implementation of the Act.[1] Included in these is a recommendation by the International Swaps and Derivatives Association, Inc. (“ISDA”) that the Commissions should grant waivers of mandatory clearing under the Act in limited circumstances where bilateral and/or systemic risk would be reduced, such as where a swap that is required to be cleared hedges the market and counterparty risk of a swap that is not able or required to be cleared.  ISDA suggests that, in such circumstances, managing both related transactions on a bilateral basis reduces risk, as the alternative (i.e., clearing one swap through a central clearing facility and managing the other on a bilateral basis) increases risk between the two counterparties as well as in the central clearing facility and the financial system more broadly.  Among other things, ISDA notes that, in granting such limited waivers, the Commissions could put in place reporting requirements and waiver limits to ensure that the use of the waivers is not designed to avoid clearing.

Separately, the Securities Industry and Financial Markets Association (“SIFMA”) sent a comment letter relating to, among other things, the end-user exemption from mandatory clearing in the Act.  An important exemption to clearing exists under the Act if one counterparty to a swap (i) is not a financial entity, (ii) is using the swap to hedge or mitigate “commercial risk” (as such term will be defined by regulators) and (iii) notifies the relevant Commission how it generally meets its financial obligations associated with uncleared swaps.  In its letter, SIFMA proposed that “commercial risk” be defined broadly as “any risk incurred by a non-financial entity in connection with its business.”  In making this recommendation, SIFMA points out that such a definition would be consistent with congressional intent, as reflected in the legislative history, to provide a broad clearing exemption for non-financial entities. It further notes that an exemption limited solely to risks directly related to the production of goods and services, and not also encompassing risks related to financing, would inhibit the ability of end users to enter swaps to decrease risks generated by their commercial activities and, as a result, inhibit their ability to ultimately produce those goods and services.


[1] Copies of the comment letters submitted with respect to each of thirty rulemaking areas identified by the CFTC may be found here.

Industry Groups Send Comments to Regulators on Collateral Segregation

 

On October 8th, ISDA sent pre-proposal comments (the “ISDA Comments”) to the CFTC regarding the segregation of collateral for uncleared swaps in light of the rulemaking the CFTC will undertake to implement Section 724(c) of the Act.[1]  The ISDA Comments note that ISDA had published in March, along with SIFMA and the Managed Funds Association (“MFA”), a white paper (the “White Paper”) describing various approaches that may be used to segregate collateral other than variation margin (most commonly, “Independent Amounts” under an ISDA Credit Support Annex) for the benefit of a dealer in respect of uncleared derivatives transactions.[2]  The White Paper discussed three approaches that could be used for these purposes, two of which contemplated bilateral custodial relationships (i.e., between the dealer and custodian) and one of which contemplated a tri-party custodial arrangement (i.e., among the dealer, counterparty and custodian).  As the ISDA Comments note, each approach has its advantages and disadvantages.  For example, the tri-party approach may provide more robust protections for counterparties, but a bilateral approach would be less costly and complex to administer and would present fewer technical legal issues.  The ISDA Comments recommend that the CFTC collateral segregation rules should allow dealers (and “major swap participants,” as defined in the Act) to make available to counterparties both bilateral and tri-party collateral arrangements, effectively allowing counterparties to choose an arrangement based on the cost-benefit considerations that they deem important.

The ISDA Comments further propose that the CFTC rules permit swap dealers (and major swap participants) to agree with their counterparties, based on the facts and circumstances that are relevant to their relationship, how certain issues related to collateral segregation should be resolved, including (i) the custodian to be used; (ii) the fees to be paid by the counterparty; (iii) which party will bear the risk of loss upon a custodian insolvency or performance failure (note that this risk is allocated to a secured party under the boilerplate ISDA Credit Support Annex); (iv) the form in which collateral may be posted; and (v) if cash is posted, how and where it will be invested and held and how gains and losses on such investments will be allocated and distributed.  Finally, the ISDA Comments note that Section 763 of the Act contains collateral segregation provisions for security-based swaps that are virtually identical to those set forth for swaps under Section 742, but that the Act does not specifically require the CFTC to conduct a joint rulemaking with the SEC on collateral segregation.  The ISDA Comments urge the Commissions to consult closely in their respective rulemakings to avoid inconsistent requirements that could introduce unnecessary costs, inefficiencies and the potential for unintended risks.

On October 27th, SIFMA also sent a comment letter (the “SIFMA Comments”) to both Commissions on several topics, including the segregation of collateral for uncleared swaps.  The SIFMA Comments note that there is currently no industry-wide standard for third-party custody of margin and that such custodial arrangements raise additional risks for swap dealers.  As a result, the SIFMA Comments recommend that the Commissions provide industry members with their views regarding the treatment of collateral supporting uncleared swaps “at an early date” to facilitate firms’ efforts to establish the necessary infrastructure to comply with contemplated rules.  The SIFMA Comments further recommend that the suggestions set forth in the ISDA Comments be considered, including that the Commissions engage in close collaboration to avoid inconsistent requirements.


[1] The relevant segregation provisions, which are found in Section 724(c) of the Act, begin on page 309. In relevant part, this subsection provides as follows:

”(l) SEGREGATION REQUIREMENTS.—

”(1) SEGREGATION OF ASSETS HELD AS COLLATERAL IN UNCLEARED SWAP TRANSACTIONS.—

”(A) NOTIFICATION.—A swap dealer or major swap participant shall be required to notify the counterparty of the swap dealer or major swap participant at the beginning of a swap transaction that the counterparty has the right to require segregation of the funds or other property supplied to margin, guarantee, or secure the obligations of the counterparty.

”(B) SEGREGATION AND MAINTENANCE OF FUNDS.—At the request of a counterparty to a swap that provides funds or other property to a swap dealer or major swap participant to margin, guarantee, or secure the obligations of the counterparty, the swap dealer or major swap participant shall—

”(i) segregate the funds or other property for the benefit of the counterparty; and

”(ii) in accordance with such rules and regulations as the Commission may promulgate, maintain the funds or other property in a segregated account separate from the assets and other interests of the swap dealer or major swap participant.

”(2) APPLICABILITY.—The requirements described in paragraph (1) shall—

”(A) apply only to a swap between a counterparty and a swap dealer or major swap participant that is not submitted for clearing to a derivatives clearing organization; and

”(B)(i) not apply to variation margin payments; or

”(ii) not preclude any commercial arrangement regarding—

”(I) the investment of segregated funds or other property that may only be invested in such investments as the Commission may permit by rule or regulation; and

”(II) the related allocation of gains and losses resulting from any investment of the segregated funds or other property.

”(3) USE OF INDEPENDENT THIRD-PARTY CUSTODIANS.—The segregated account described in paragraph (1) shall be—

”(A) carried by an independent third-party custodian; and

”(B) designated as a segregated account for and on behalf of the counterparty.

[2] For a summary of the White Paper, see DMIR March 2010.

Lehman Reaches Settlement with Perpetual in Dante Case

 

On November 17th, Lehman Brothers Special Financing Inc. (“LBSF”) and its official unsecured creditors’ committee filed a joint motion to stay BNY Corporate Trustee Services Limited’s (“BNY”) appeal for 90 days in the “Dante” matter, pending final settlement of the dispute between LBSF and Perpetual Trustee Company Limited (“Perpetual”).

The reason for the motion was LBSF’s settlement in principal with noteholder Perpetual, an Australian trustee with noteholders of its own.  On September 20th, the United States District Court for the Southern District of New York granted to BNY leave to appeal the bankruptcy court’s January decision.  This decision had voided certain document provisions related to the Dante credit-linked note program providing for the subordination of LBSF’s rights as swap counterparty to an early termination payment when the swap counterparty or one of its close affiliates went into bankruptcy.‪  In effect, the bankruptcy court had held that these subordination provisions—which effectively flip LBSF’s right to get paid from above that of the noteholders to below that of the noteholders—constitute unenforceable ipso facto clauses under the U.S. Bankruptcy Code (the “Bankruptcy Code”) and that any action to enforce the subordination provisions would violate the automatic stay provisions of the Bankruptcy Code.  BNY holds the collateral subject to this dispute and had brought the appeal in its capacity as trustee.[1]

The motion for the stay was granted and, on November 24th, LBSF filed another motion seeking the court’s approval of a settlement with Perpetual.  If the final settlement between LBSF and Perpetual is approved by the court, it is expected that LBSF will then request that the BNY appeal be dismissed.  Such a dismissal will leave uncertainty as to the enforceability of similar flip clauses.


[1] For a detailed summary of the Dante matter, please see DMIR October 2010 and DMIR January 2010.